Economics 10/02/2010: Minumum wage and unemployment benefits

Two weeks ago in my Sunday Times article (see here) I wrote about the long-term effects of the minimum wages. Instead of dealing with the losses of economic competitiveness from Irish high minim wage, I elected to focus in the article on the distorted incentives and reduced training for potential and actual minimum wage recipients. Interestingly, these adverse effects are nearly identical for minimum wages and unemployment benefits.

Last week’s research paper from Zafar Nazarov of RAND, academic think tank in the US and Europe, titled The effect of the unemployment insurance wage replacement rate on reemployment wages, showed that higher unemployment benefits lead to lower wages commanded by those who manage to re-enter employment. In addition, higher wage replacement rate under unemployment benefits ‘depresses depresses the prospect of finding full-time work while increasing the prospect of finding part-time work”. To summarize, therefore, higher unemployment benefits paid hurt those unemployed who find a job in the future and lead to lower quality of jobs available to the previously unemployed.

Qui bono, then from higher unemployment payments? Those on permanent welfare, of course. Since they do not face a prospect of gaining a job in the future, they face none of the costs of higher unemployment benefits. But as their own pay is linked to unemployment benefits through social fairness arguments, there is all the upside of higher rates. Oh, the bizarre world of state-controlled wages, unemployment insurance and welfare benefits. Makes banks’ s shenanigans sound pretty banal.

Economics 08/02/2010: Nama v IMF revelations

Fair play to the Irish Times' Simon Carswell (here) for unearthing through FOI request that IMF note which back in April last year told the Irish Government that Nama will not restore lending in the economy.

This, of course, is the old news to many of us. You can search this blog for 'restore credit' and other key words and see posts going back to April 2009 with exactly the same analysis. Outside of this blog, I warned on the matter in my columns in Business & Finance and in the Sunday Times, in articles in Irish Mail, Irish Independent, Irish Times, in numerous appearances on BBC, Bloomberg, RTE, TV3, Newstalk, TodayFM and so on. Even in the likes of Wall Street Journal and numerous international print outfits. Several other analysts - namely Professors Brian Lucey and Karl Whelan, banking specialist Peter Mathews, economist Ronan Lyons and others - all have done so as well.

But what is new is the fact that this IMF opinion was known to the Government and its advisers who, having buried it from public view, have gone out on a prolonged PR campaign, in effect liberally treating the truth about Nama. Ditto for NTMA and Nama officials. That public representatives and officials engaged in such an act is a betrayal of public trust. It is, simply put, a deception of public opinion.

Quote from Irish Times: "Speaking at the publication of the Nama legislation last September, Mr Lenihan said Nama would “strengthen and improve” the funding positions of the banks “so that they can lend to viable businesses and households”. Taoiseach Brian Cowen had said the Government’s objective in restructuring the banks was to generate “more access to credit for Irish business at this critical time”"

But there is more to Simon's article (my emphasis):

"In an internal e-mail dated June 6th, 2009, ...senior department [of Finance] official Kevin Cardiff warned against making public any official estimate for the losses faced by the banks, saying that the department had not made this information public. “We naturally shared with the IMF team our informal views on the range of possibilities, but would be uneasy about seeing these formalised,” said Mr Cardiff, who has since been appointed secretary general of the department."

This is uncomfortably close to an admission that the DofF willingly withheld crucial information about Nama from the official communications in order to avoid this information being disclosed publicly through future FOI requests. Again, I am not a conspiracy theorist, but what else does one need in terms of proof that the Government and its officials knowingly engaged in acts of public deception when they were making claims about

• Nama's expected impact on credit supply;
• Nama's expected costs and losses.

Tellingly, IMF estimated that Irish banks will face losses of up to €35 billion and that the DofF was informed by them of this figure. If you look at my posts on Nama Trust, expected Nama losses and the cost of nationalizing the banks - my estimates from early 2009 on consistently show that the at risk assets of Irish banks covered by Nama are around €32-37 billion - bang on in line with IMF's estimate. Again, I wasn't the only person providing these estimates.

The Government, Nama, NTMA, DofF and the Central Bank - all have elected to completely ignore all independent analysis that has been performed by myself, Brian Lucey, Karl Whelan, Peter Mathews and others. And yet, not a week goes by since September 2009 in which the Government is forced to admit that we were right in our estimates and forecasts.

While the Government continues to spend hundreds of thousands of our euros on PR spin doctors and 'advisers'. At the same time, the entire staff and executive structure of Nama have been loaded with either 'quiet men' of 'I have no interest in defending taxpayers' type or outright 'yes men' for the Government.

Let me reproduce here few quotes that a reader posted in his reply to one of my earlier blog posts:

"The government did an "A1" job in their spin on NAMA, they persuaded the shareholders into voting for NAMA so that the banks would avoid nationalisation. Blindfold nationalisation is inevitable. Memorable brainwashing quotes:

• "NAMA is the only game in town"
• "there is no easy way out"
• "We need NAMA to get credit flowing into the economy"
• "Ireland is getting "NAMA Money" from the EU"
  
• "There will be no more 100% nationalisations"

And so on...

Disgraceful, really!

Do send me other quotes from public officials that you feel might have been outright deceiving in nature and I will post them on the blog!

Economics 08/02/2010: PIIGS or PIGS?

For those of you who missed my article in yesterday's Sunday Times, here is an unedited version of it, as usual:

This week marked a new low for the euro zone. Despite all the posturing by Brussels officials about Greek deficits and the incessant talking up of the euro by the ECB and the Commission, the events clearly show that the common currency is lacking credible tools to bring order to public finances of its member states. Thanks to the clientilist politicians and the electorate, keen on piling up debt to pay for perks and inefficient public services, the Greeks really blew it. Then again, given their performance over the last fifteen years – inclusive of massive persistent deficits and outright manipulation of official data to conceal them – about the only surprising thing in the ongoing Greek tragedy is that their bonds are still trading at all.

Much more interesting events, related to the Greek debacle, are unfolding in Ireland. Boosted by the factually erroneous, yet ideologically pleasing statements by international observers, Ireland’s image in the euro area has improved significantly since the publication of the Budget 2010.

Which, of course, is out of line with economic reality on the ground. Far from exiting the PIIGS club of sickest euro economies, comprised of Portugal, Ireland, Italy, Greece and Spain, we are now looking like a country to which the wrath of international bond markets might turn next, once Greece is dealt with.

Let me explain.

This week, writing in the Financial Times, a respected economist, Nouriel Roubini has clearly shown just how escapist is the current thinking about the state of public finances in Ireland.

"The best course [for Greece] would be to follow Ireland, Hungary and Latvia with a credible fiscal plan heavy on spending cuts that government can control, rather than tax hikes... This approach is working in Ireland – spreads exploded as public debt ballooned to save its banks, but came back in as public spending was cut by 20 percent."

Professor Roubini’s comment was echoed later in the day by ECB’s President Jean-Claude Trichet who lent unprecedented amount of good will to the ‘right policy choices’ made by Ireland.

Even our Department of Finance has not, officially, claimed such a thing.

First off - Irish fiscal adjustments from the beginning of the crisis to-date are split approximately 50:50 between higher tax burden and ‘savings’. This debunks Professor Roubini’s general analysis of our policies.

But more importantly, it shows that our Government policies have focused on providing fiscal and financial supports to a select few at the expense of the entire economy. Some €70 billion plus of real future taxpayers’ money has been already committed and €10-15 billion more is still waiting to be deployed post-Nama to rescuing Irish banks’ bondholders. Slightly less comfort was given to the developers who will get a three year holiday on loans repayments courtesy of the taxpayers.

In a real world, economic recovery can only start with ordinary households and businesses. In Ireland, public policy assumes that raising taxes and charges at the times of shrinking incomes and revenues to sustain banks bondholders and narrow interest groups within this society passes for ‘doing the right thing’.

International observers might overlook this fact. For them the costs of encountering a deep and prolonged Irish recession are nil. But for us, the spectre of the 1980s is painfully evident.

In contrast to Greece, Ireland has been hit by an unprecedented, in magnitude and duration, economic recession. Our house prices bust and financial assets collapse was deeper than that of Greece. We also are facing a much more severe banking crisis and a significantly more dramatic rates of deterioration in public deficits. Ditto for our unemployment levels and credit contraction rates.

Our sole claim to better health is a substantially lower existent public debt burden. Alas, this too is optical. In real per capita terms, total levels of debt in Ireland (combining public and private debts) are several times greater than those in Greece.

Even when it comes to budgetary adjustments – as far as Governments plans go – the Greeks are ahead of us. Starting from marginally higher deficit in 2009, the Greeks are planning to bring their deficit to within 3% of GDP limit by 2012. We are planning to do the same by 2014. Of course, both plans are unrealistic, but whilst the EU Commission will attempt to force the Greeks to comply with their target, no one will be closely monitoring our Government’s progress.

In summary, we are nowhere near exiting the PIIGS club.

But let’s take a look at the ‘Love the Irish Policies’ media circus going on in international press. Contrary to Professor Roubini statement, Irish Government has been unable to achieve meaningful cuts in public spending to-date. Instead, we delivered a reallocation of some funding from one side of public expenditure to another. ‘Cuts’ in majority of departments have been simply re-diverted to social welfare and Fas.

By Government-own admission, there will be no net reduction in public expenditure in Ireland since 2009. Department of Finance’s "Ireland – Stability Programme Update, December 2009" provides some stats. In 2009, Gross Current Government Expenditure in Ireland stood at €61,108 million. In 2010 it is budgeted to reach €61,872 million. The latter figure does not include the cost of recapitalizing the banks post-Nama. In 2011-2014 the Government is projecting the Gross Current Expenditure to rise steadily from €63,518 million to €65,768 million.

To Professor Roubini this might look like savings, but to me it looks like the Government continuing to leverage our economic future in exchange for avoiding taking necessary medicine now.

The only reasons why our deficits are expected to contract from 2011 through 2014 is because the Government has been slashing public investment, raising tax burden and is banking on a robust recovery after 2010.

Overall, DofF plans for a 2.8% cut in the General Government Balance in 2010, and that will leave us (per their rosy forecasts on growth and tax revenue) at 11.6% deficit relative to GDP, down a whooping 0.1 percentage point on 11.7% deficit achieved in 2009. Adding expected costs of banks recapitalization, our Government deficit can easily reach beyond 14-15 percent of GDP this year. Greece is now aiming for 8-9% deficit this year under a watchful eye of the Commission. Do tell me Budget 2010 qualifies us for being treated as a stronger economy than Greece.

Stripping out its interest rate bill, Greece is planning for lower per-capita state borrowing in 2010 than Ireland. But Irish Exchequer is planning to raise its borrowing this year by 3%. If international observers are correct, why would the Government that managed to cut its spending by 20% increase its borrowing? That would only make sense if the revenue is expected to fall by more than 20%. Yet Budget 2010 assumes tax revenue decline of only 4.7% in 2010 and an increase in non-tax revenues.

So what has Irish Government done to deserve such a sweet-heart treatment from the EU and Professor Roubini?

One word comes to mind – smart marketing. Budget 2010 simply took €4,051 million from one Government pocket and loaded it into another. Then, the Government promptly reversed itself out of some of the higher profile cuts, such as those imposed on higher earners in the public sector. Even at the highest point of estimates, the savings – before they get cancelled out by rising spending and falling revenue – amount to the total of 6.42% of the Gross Total Expenditure in 2009.

After 2 years of the deepest economic crisis in the euro area, we are now facing one of the heaviest upper marginal tax burdens in the developed world, and a deficit that is simply out of control. Hardly the road map to a recovery.

Economics 07/02/2010: Human Capital, Immigrants and Social safety Nets

A very interesting piece of research that tends to support my view that higher minimum wages and more extensive welfare nets / social services nets are acting to reduce overall levels of productivity amongst the immigrants.

One paper, published this week, titled Indian Entrepreneurial Success in the US, Canada and the UK, by Robert W. Fairlie - University of California, Santa Cruz, Harry Krashinsky - University of Toronto, Julie Zissimopoulos – RAND and Krishna B. Kumar – RAND (available here) takes a look at the differences in entrepreneurship (incidence and outcomes) and education amongst one large sub-group of immigrants to the US, UK and Canada. Having a culturally homogenous and relatively large group of immigrants allows the authors to set aside the need for measuring sending country attributes, thus improving substantially the accuracy of their results.

What they found is pretty interesting.

Indian immigrants in the US and other wealthy countries are successful in entrepreneurship. But how successful these entrepreneurs are once they reach different countries and encounter different social systems, and what are the sources of their success?

The study finds that “in the US Indian entrepreneurs have average business income that is substantially higher than the national average and is higher than any other immigrant group. High levels of education among Indian immigrants in the US are responsible for nearly half of the higher level of entrepreneurial earnings while industry differences explain an additional 10 percent. In Canada, Indian entrepreneurs have average earnings slightly below the national average but they are more likely to hire employees, as are their counterparts in the US and UK. The Indian educational advantage is smaller in Canada and the UK contributing less to their entrepreneurial success.”

Hmmm… why so, you might ask?

Immigrants are most likely to enter both the US and UK as ‘family sponsored.’ Since the 1960s U.S. immigration policy has strongly favored family reunification. The UK’s immigration policies over the past four decades have shifted towards emphasizing family reunification and employment. On the other hand, Canada's point-based system which awards immigration admission points based on education, language ability (English or French), years of experience in a managerial, professional or technical occupation, age, arranged employment in Canada, and other factors leads to more skilled immigrants compared to the US.

So far so good – Canada has longer lasting and much more selective immigration policies than the US and UK.

Because of the point-based system, in Canada, roughly half of all immigrants are admitted through employment-based preferences. In contrast, slightly more than 10 percent of immigrants in the US are admitted under this classification.

Again, sounds like Canada should be really the land of entrepreneurial and higher quality immigrants.

The related category of employment creation or investors who face minimum net worth and business experience requirements, and self-employed immigrants who must have relevant experience in occupations. A larger (but still relatively small – just 7%) share of immigrants in Canada are admitted under these policies than in the US (0.1%) and UK (2.4%).

So, ex-ante data analysis, it is pretty clear that “Canada's point-based immigration system results in a higher share of employment-based immigrants compared to the US and UK. On the other hand, the UK admits a much higher share of immigrants under its refugee and asylee programs than the US or Canada. All else equal, we would expect skill levels of immigrants to be the highest in Canada and the lowest in the UK.” (emphasis is mine)

In other words: the authors “find some evidence that the educational advantage of Asian immigrants compared to the national average is lower in the UK than in the US, [consistent with differences in immigration policies]. But, we also find that the educational advantage in the US is higher than it is in Canada, which runs counter to the greater emphasis of Canada's immigration policy on rewarding points for the general skill level of immigrants.”


Why? “A more generous redistribution system, more egalitarian earnings, and other institutional and structural factors, however, may make Canada less attractive to higher skilled immigrants such as Indian immigrants.”

Boy, this is some statement – especially considering the EU policies to achieve ‘Social’ economy – economy based on greater earnings equality, greater rights-based outcomes equalization and maintaining a very generous welfare and redistribution systems. And this is serious, folks. Canada, US and UK are much younger – demographically – societies than EU-core states. This means that in general, the EU has a much more acute need to import younger entrepreneurial talent and skills in order to pay even comparable welfare rates to those in Canada, US and UK. Let alone to afford a more generous system of benefits. The prospects of this happening are not that good, folks.


Let us get back to the study, though:

“We find that Indian entrepreneurs are much more successful than the national average in the US. Indian businesses also perform well in Canada and the UK, but the evidence is not as strong. In the US, Indian entrepreneurs earn 60 percent more than white entrepreneurs and have the highest average business income of any immigrant group.”

No, wait – income inequality is actually favoring ethnic minorities in the US? Without an EU-styled rights legislation that polices allocations of income to specific ethnic groups? Who would have thought that to be possible!

“Estimates from business-level data sources also indicate that Indian firms have higher profits, hire more employees, and have lower failure rates than the average for all U.S. firms.”

Ouch - higher profits = hire more workers + have lower failure rates? And all without help of SIPTU/ICTU/etc to protect the interests of workers and to curb profiteering? Who could have thought?


But what drives such astounding results?

“To explain to relative success of Indian entrepreneurs we focus on the role of human capital. ...We test the hypothesis that a highly-educated Indian entrepreneurial-force is responsible for their superior performance in business. Indian immigrants in all three countries have education levels that are higher than the national average, and in the US the education levels of Indian immigrants are particularly high relative to the entire population. In the US, 68 percent of Indian entrepreneurs have a college education which is twice the rate for whites or the national average. Some of the variation in the education of Indian immigrants across the US, Canada and UK is likely due to immigration policy. Another possibility is that the higher returns to education in the US result in a more selective immigrant pool in the US compared to Canada and the UK.”

Bu wait – ‘higher returns to education’ = greater income inequality between educated and non-educated. Again, who could have thought that this might be a good thing, especially for a ‘knowledge economy’?

“When we examine business income, we find large, positive effects of education in the US and Canada. We also find large positive effects of education on employment in Canada, but smaller positive effects in the UK. The findings for education imply that the relatively high levels of education among Indian entrepreneurs have a large effect on business performance at least in the US and Canada. Decomposition estimates provide exact estimates of the contribution of higher levels of education among Indian entrepreneurs to their higher business incomes and employment levels.

• In the US, higher levels of education among Indian entrepreneurs result in a business income advantage of 21 log points, which represents 43.9 percent of the gap.
• High levels of education also contribute substantially to why Indian entrepreneurs earn more in Canada (12.5 log points), but the difference is not as large as in the US.
• “The combination of the larger education advantage held by Indian entrepreneurs and the larger return to education is responsible for the increased importance of education as an explanatory factor in the US compared to Canada.
• “In contrast to these results, the smaller educational advantage and lower returns to education in the UK result in less explanatory power in the UK.”
  

But sectoral and cultural decompositions also matter: “Lower concentrations of Indian entrepreneurs in agriculture and construction, lower female share*, higher marriage rates, and favorable regional distributions also generally contribute to why Indian businesses perform better than white businesses or the national average.”

Again, give it a thought, folks. The above says that Indian entrepreneurs are so spectacularly successful in all three countries because they avoid investing in ‘losing’ sectors and regions. So where does it put state-led efforts to pump money into such ‘losing’ sectors as, for example, agriculture? And where does this leave Ireland’s ‘National Spatial Development Plans’ that reallocate cash to ‘losing’ regions/areas? In the category of ‘luxury goods’ – an affordable (in certain times) cost of keeping at bay social discontent amongst those who are falling behind?

And it also says that higher marriage rates are positively associated with higher returns to entrepreneurship. Who could have thought?


Some food for thought for our immigration policy bureaucrats and our national development authorities, then…



*[Aside - the issue of lower female share of entrepreneurship is, in my view, a simple statistical legacy. Women entrepreneurs tend to run businesses that are on average younger than those for men, hence, some increased risk in statistical measures. Over time, I would expect as female entrepreneurship gains fully similar footing in types of business, sources of financing etc as male entrepreneurship, this difference will disappear completely.]

Economics 06/02/2010: Nama stalling at the EU doorsteps

For those of you who missed my Thursday musings on Nama in the Irish Daily Mail, here is an unedited version of that article:

Two friends from the distant land of global finance have caught up with me the other day. ‘What’s going on with your Nama?’ they demanded to know.

Their concerns were about the latest hiatus created around our Bank Rescue scheme.

Yesterday’s news that NTMA is to take over management of the Exchequer affairs relating to bank shares bought with taxpayers’ cash is the case in point. Apparently, NTMA – the parent institution to Nama – will hold talks on capital needs with the banks as well as engage in their realignment or restructuring. It will also advise on banking matters, and crisis prevention, management and resolution. Just exactly can this task be achieved without creating a severe conflict of interest between NTMA and Nama, or without stepping on the heels of the Central Bank and Financial Regulator is anybody’s guess. But the bigger problem here is whether such a role for NTMA will constitute an undue interference in the financial markets for banks shares.

This activist approach to managing Nama news is not new, however. Following the quiet publication of the last piece of legislative jigsaw, Nama (Designation of Eligible Bank Assets) Regulations 2009, on the day before Christmas Eve, our Government has gone into an overdrive, trying to spin Nama as a panacea for all economic ills of the country.

Nama was painted as a socially responsible undertaking that will be reporting to the Government ministers on the issues of ‘social dividend’. It will provide housing for the poor and will take off the market vast surpluses of unwanted properties. Nama will also deliver a healthy dividend by charging local authorities for this ‘service’. But the local authorities will still somehow come on top by saving money.

Perhaps mindful of having produced too much gibberish of the above variety, our public representatives have started talking up the discounts that Nama will apply on loans it buys from the banks. Just 6 months or so ago Nama enthusiasts were saying that a 12-20 percent average discount will reflect the ‘true long term economic value’ of the loans? Now we are into 30-35 percent haircuts and rising.

The iron logic of finance tells us that the greater the discount Nama imposes the greater proportion of the original loan will have to be written down by the banks as a loss. This will require fresh capital, of which the taxpayers are the only source for no investor will be willing to buy new shares in Irish banks voluntarily.

By my estimates from some 9 months ago, the Irish banks will require Euro 10-13 billion of fresh capital the minute Nama goes through their books. After months of ignoring this prediction, the Government now admits as much.

But wait, as the discounts estimates increase, so are the concerns in Brussels and Frankfurt about Irish Government’s plan. First, the ECB is now seriously worried about the quality of Irish banks collateral deposited in its vaults. Second, the EU Commission is more concerned that approving Nama will produce poor optics internationally, as Nama will be openly buying trash with taxpayers cash and Europe’s approval.

As if these two issues were not enough, we now have two official versions of financial theory – the Frank Fahey’s Proposition and an Alan Ahearne’s Theorem.

The former claims that ECB is giving us a free lunch – a deeply discomforting statement from ECB’s point of view as it undermines the bank’s credibility.

The latter states that the banks, repaired by Nama, will “stimulate demand” for consumer loans. So our economic policy is being shaped by people who think that the banks can drive up demand for credit in the economy stuck in negative equity, with consumers facing higher taxes and falling incomes. And, of course, there is an added concern about the ordinary homeowners and their bad debts. As the Government is preparing to create another massively risky scheme for ‘helping’ defaulting mortgage holders, the Commission is starting to think – was Nama a limited undertaking, or will Irish banking crisis spill over into a general economic crisis as well.

Then there is an ongoing saga with loans. Back in the days before Nama Bill was passed, we were told that the Government has an excellent idea as to what security they can get on Nama-bound loans. It turns out they hadn’t a clue. As Namacrats are discovering, the loans held by the Irish banks often have a secondary claim to the underlying assets. And, they are finding that the poorer the loan the lower, usually, is the underlying security.

Suppose the bank has a loan for Euro 10 million secured against the property worth Euro 5 million. Suppose Nama buys the loan for the face value of the underlying property, implying a haircut of 50%. But if loan seniority is secondary in seniority, given the recent cases of our top builders going through the insolvency courts, the post-default value of the asset is somewhere between half a million and nil. Subtract the legal costs of fighting the borrower and better-secured lenders in the courts. The state will be lucky to get a euro from the deal.

This arithmetic is not escaping the ECB. Since December, we are painfully aware of Frankfurt’s intentions to close the discount window through which Irish banks have already pumped some Euro 98 billion worth of junk-rated assets in exchange for cash. By all Euro area standards, Ireland – a minnow accounting for roughly 1.8 percent of the entire common currency economy – has swallowed about 19% of all cash released by the ECB since the beginning of the crisis. More than any other country in absolute terms. Add to that the prospect of Euro 59 billion worth of Nama bonds, plus another Euro 10-12 billion for banks recapitalization, Irish banking system bailout can cost ECB up to Euro 170 billion in loans secured against, you’ve guessed it – unfinished estates in the middle of nowhere.

So understandably, the ECB folks are worried. By May they will start reversing junk securities they loaned against out of their vaults and back into the banks. Should they succeed, Irish taxpayers will be stuck for more cash to plug the new hole in banks balancesheets.

Which in turn will drive the quality of our collateral even lower. Mortgage rates will climb by 100-150 basis points for those of us who are still paying them down. Cost of credit for businesses will rise well into double-digit figures. Credit cards, car loans, consumer loans – all will become as rare in Ireland as polar bears in Sahara. Taxes and charges will increase – by 15-20 percent on average over 2011-2013. Instead of banks stimulating demand for credit, as Alan Ahearne suggests, Ireland Inc will be back on the slippery slope toward deeper recession.

Ultimately, it is the prospect of Ireland sliding back to rival Greece as the drag on the Euro that has been bothering my friends, as well as the ECB and the EU Commission. Sadly, their concerns are our last line of defense against Nama.

Economics 05/02/2010: Prepare for a new slide

Fasten your seat belts and prepare for a new round of bad news. Globally this time around.

All data for January-February is showing that the pressures of jobless recoveries around the world, coupled with continued weaknesses in financial sector and money supply (despite unprecedented stimulus deployment and helicopter drops - more like blanket bombings - of liquidity) are over-powering the weak positive momentum in growth.


December retail season was, officially, a disappointment – down 1.6% on 2008 season across the euro area. The headline Eurozone Manufacturing PMI reached 52.4 in January, highest reading for two years. The index stood at 51.6 in December, so the rise was marginal.

There were noticeable disparities in performance between national manufacturing economies. Countries reporting an increase in output were Germany, France, Italy, Austria and the Netherlands. All improved on December. Spain, Ireland and Greece all recorded lower output and faster rates of contraction.

Sector data indicated that capital and intermediate goods fared best in January. Growth consumer goods production is falling below that achieved in the previous month.

Growth of new orders was the strongest since June 2007 and faster than the earlier flash estimate. The gain in the index between its flash and final releases was the greatest since flash PMI data were first compiled at the start of 2006. New export orders rose at an above flash estimate pace that was the quickest since August 2007. See Ireland PMI in my Sunday Times article this week.

Despite rise in core PMI, manufacturing continued to shed jobs during January, across the Eurozone.

Core retail sales (ex-motors) in Germany were weaker in November than previously reported (down 1.7% mom) but rose 0.8% mom in December. Car sales are down 40% quarter on quarter –driven by the end of the scrappage scheme. Which, of course, shows that Irish experiment with temporary programmes of subsidies is unlikely to work. Interestingly, in Germany, scrappage scheme has benefited primarily foreign manufacturers. Of course, the reason for this is that German car makers are primarily at the top of the price proposition distribution and in a recession, subsidy or none, they will suffer. Foreign care makers sales rose 26% in December and 38% in January, before the scrappage scheme shut down. Domestic car sales were flat.

Sign of troubles ahead for exports growth – German manufacturing orders are down 2.3% in December while output contracted 2.6%.

Greece and Portugal are clearly in the news flow. Both have no market credibility when it comes to their deficits. And the reports from the ground are even worse with virtually all vox-pop reporting suggesting that populations of both countries are in deep denial of the reality. People are talking about ‘fat cat managers earning hundreds of thousand euros’ while ‘ordinary people are suffering’. Long legacy of communist and socialist politics in both countries is clearly evident in the popular unwillingness to face the music.

The next points of pressure will be Ireland and Spain.

On Ireland’s fiscal position and PMIs – read my Sunday Times article this weekend.

On Spain: the country is about 3 times bigger in economic terms than Greece and Portugal – accounting for roughly 11.8% of the euro area GDP. Troubles here will be a much bigger problem for the Eurozone than all the rest of the PIIGS (less Italy) combined. Meanwhile, Spain’s unemployment is rising (just as Ireland's), adding some 125,000 to the dole counts in January. 19% of Spaniards are now officially unemployed, as opposed to Ireland’s 12.7%. In terms of hidden unemployment, Spains problems are also much tougher than Ireland’s especially since grey markets for construction workers which sustained unofficial employment during the boom are now shut in Spain.


Credit is still tight in the euro area and the FX valuations are still around $/€1.36 – way too high for an exports recovery.

It is now painfully clear that the only thing that can resolve euro area’s problem would be a massive one-off emission of liquidity directly into the government budgets. To do this, the ECB can set a target of, say, €1,000 per capita for the eurozone economies, disbursed to each country based on their population. Anything else simply won’t do.

But even such a measure will not provide sufficient support for Greece, Portugal, Ireland and Spain – only a temporary reprieve.


UK’s economy is also in stagnation pattern with full-time employment still falling, individual, insolvencies up to record highs. The uptick in house prices in late 2009 is likely to have been temporary and driven by speculative ‘testing the water’ by international investors. Manufacturing PMI is up robustly January to 56.7, its highest level since October 1994, and from 54.6 in December. The increase was driven by new orders, which rose at the fastest pace in six years, as well as companies' efforts to clear backlogs of existent orders. It remains to be seen if this pace of improvements is sustainable. Services sector PMI meanwhile contracted rapidly from 56.8 in December to 54.5 in January, marking the slowest activity in five months.

Here is a little fact to put things into perspective – manufacturing accounts for less than 20% of the UK economy, while services account for 76%.


Overall, this recovery is coming along with more stress and strain on the labour markets. All global indicators are now appearing to have peaked back in Q4 2009, with the new year starting on downward trajectory. Inventory cuts passed in previous quarters are now being worked out and there is little sign this process will be picked up by a structural increase in new orders. All in, jobs growth is now severely lagging that achieved in the end of the previous recessions. In this environment, growth favours the US where jobs cuts were much more significant and early, allowing firms to rebuild their margins before the onset of any demand improvements. Eurozone is, in contrast, toast. Indicative of this is the volume of global trade – with Baltic Dry Goods index down to 2704 today as contrasted by 3335 reading 3 months ago.


Strategically – I would short Europe as an index, but look for low cost medium margin operations for a long position.

Economics 04/02/2010: McKinsey gets banal with risk

Latest McKinsey Quarterly (here) contains an article on global risks. Sub-titled "Top risk forecasters highlight their picks for this year's economic and political hot spots", the article is short and... really, really, really banal.

Here it is in its full glory (emphasis is mine):

Where will the greatest risks — known and unknown — flare up on the global business landscape this year? In this roundup, three prominent forecasters scan the horizon. [Notice the use of the future tense, forward-looking language]

...Economist Intelligence Unit's latest global business risk assessment highlights ...growing political instability from rising global unemployment, macroeconomic risks as stimulus measures fade, and financial-system risk spreading to sovereign debt in Greece and other countries.

European fiscal divergence makes the list as well at the Eurasia Group, which also sees diminished appeal of economic partnership between China and the United States raising concern, while Iran faces growing pressure at home, regionally, and globally.

And the World Economic Forum's 2010 Global Risks report focused on, among other risks, the barriers to growth posed by structurally deficient or obsolete infrastructure, the spread of chronic disease, and illicit trade."

Let me re-list them:

• 'growing political instability from rising global unemployment' - hmmm, wasn't that already apparent in Greece back in December? or in Ireland during local and European elections? or in the US in the last Presidential elections? I can go on and on;
• 'macroeconomic risks as stimulus measures fade' - you don't need EIU's forecasting powers to spot that one - everyone trading in financial markets has been factoring it into valuation for months;
• 'financial-system risk spreading to sovereign debt in Greece and other countries' - now what's new here (given the last 15 months of erratic markets behavior and record bond issuance) is the 'financial-system risk spreading' bit. Which financial-system risk? It is a purely nonsensical statement, unless one means by it that the bond finance system itself is under threat (US Treasuries? German bunds?);
• The risk of 'European fiscal divergence' has been with us for some 5 years now and has been growing steadily;
• 'diminished appeal of economic partnership between China and the United States' - but, folks, 'economic partnership between the two is a traffic of investment from US into China in return of exports from China into the US. This 'partnership' was coming under pressure for decade now. It really started to unravel with undervaluation of yuan bearing on the dollar balance of trade in 2006-2007. Since then, the prospect of the 'diminished appeal' was pronounced in US politics, culminating in the last Presidential Campaign. President Obama has been promising a protectionist corporate tax system overhaul to 'diminish appeal' of investing in China for US MNCs since before his election. I wonder if this is really a risk for 2010;
• 'Iran faces growing pressure at home, regionally, and globally' - oh no, who could have guessed. Certainly 2009 elections - with violent clashes, murder of internal opposition leaders etc, all caught on TV news and broadcast around the world were not a sign of 'growing pressures at home'. And Russia moving alongside the US and Europe to attempt to curb Iranian nuclear ambitions (a process that started back in 2006) is also not a sign of 'growing pressures... regionally and globally'. In short - this 'prediction' is too - old news.

Only WEF actually returns some interesting (aka not-banal) risks - infrastructure constraint on growth is a good one (although there is an element of 'old news' here as well, as crumbling bridges in the US and collapsing new builds in Korea have been with us for almost 10 years now). WEF could have added to it the lack of Governments' capacity to find funding to repair this crumbling infrastructure as a new-ish constraint - post-crisis. They did not...

Illicit trade being on the rise? Predictable risk - in any recession, black markets grow.

But the pearl is the prediction of chronic diseases spreading in 2010. Of course 'chronic' refers to the rate of onset of disease and development being spread over longer time horizon (at least 3 months). So how would we know if chronic disease is spreading in the remaining 10 months of 2010? especially ones with gestation periods measured in years?

Precious stuff, really. Makes me want to create my own list of forward-looking risks for 2010 and beyond. It will start with something impactfull, like "Parts of the world will experience droughts while other parts will get flooded. Grey skies will cover Ireland on many occasions throughout 2010."

Any suggestions what else to include?

Economics 04/02/2010: Nama - riskier than Anglo?

I just came across a very interesting paper, written back in November 2007 and published by the Bank for International Settlements as a Working Paper No 238.

As a proposition: I will use the study results to argue that Nama is a more risky undertaking than the Anglo Irish Bank.

Authored by Ryan Stever and titled “Bank size, credit and the sources of bank market risk” the paper “…examines bank risk by investigating the equity and loan portfolio characteristics of publicly-traded bank holding companies.” The study is based on the US banks, with sample being a panel of ‘at least 339 publicly trades BHCs at each point in time” for the period of 1986-2003. “These range in size from American Bancorporation at $31 million in book assets (200 employees) to Citigroup at $1.26 trillion (over 280,000 employees).”

“Unlike the pattern for non-financial firms, equity betas of large banks are two to five times greater than those of small banks. In explaining this, we note that regulation imposes an effective cap on banks’ equity volatility. Because the portfolios of small banks are less diversified, this cap has a greater effect on small banks than large banks.”

In other words, there is plenty of evidence that even when effective, regulators can induce some unintended consequences onto the banking system and that these consequences, if unaddressed can lead to systemic failures. Here is how it works:

• Regulators (and/or shareholders through exercise of their voting rights) place a limit on the total volatility of each bank’s assets regardless of size, which tends to minimize bank risk; however
• Small banks have more idiosyncratic risk inherent in their loan portfolio “because they cannot diversify away idiosyncratic volatility as well as large bank” (practically – smaller banks are more specialized, making their loans books more exposed to idiosyncratic strategy risk).
• Smaller banks inability to diversify comes about in “a number of different ways – for example; less total loans held, less diversity in borrower type (they do not have access to large borrowers) and geographic restrictions (small banks tend to be more localized);
• Because their total equity volatility is limited by regulation smaller banks must then find a way to eliminate their idiosyncratic volatility that is in excess of larger banks’ idiosyncratic volatility.

To do this, small banks do not necessarily pursue higher levels of equity capitalization or lending to different sectors in the economy – in other words, they do not strive to become like larger banks, but instead they either

• make loans with less credit risk than large banks (Swiss private banks, for example). This has the effect of reducing idiosyncratic volatility (as desired) and also reducing the beta of each loan (and thus the equity beta of small banks); or
• demand more collateral (e.g. Irish banks).

Of course, the problem with selecting the latter path way (collateral beefing up) as opposed to the penultimate pathway (more conservative, risk-sensitive lending) – as Irish banks should have learned from the current crisis – leads to additional problem, not highlighted in the study. This problem is manifested in the selection bias induced onto collateral – smaller banks opting for higher collateral requirements will take on less diversified collateral that is more likely to be positively correlated with their own (risk-skewed) loans books.

Thus collateral risk becomes positively correlated with loans risk.

Just think of what type of collateral Liam Carroll was supplying for his property development loans? You’ve guessed it – property-based collateral.

In fact, the study does find that small banks did not lower their equity volatility through lower leverage. Instead, “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.”


What are the lessons for Nama from all of this? I am afraid not very positive ones. Nama is setting out to purchase loans on the basis of their collateral. Loans that are in distressed with collateral that has breached covenants due to precipitously declining valuations. Guess what – collateral risk is positively correlated with loans risk here from the start. Can this correlation be diversified? Yes, but not within Nama setting.

Remember, Nama promised to take good and bad loans together and mix them to derive cash flow. But these loans are all written against the same types of collateral as in:

• Same instruments;
• Same geography;
• Same vintages;
• Same currencies and so on.

In language of diversification – which loans returns are orthogonal to each other? Answer: none. Hence, no diversification is possible.

Take this back to the study findings and treat Nama as a sort-of-a-bank undertaking (with no deposits, but plenty of loans, although of course it does not matter, because Nama is not facing market funding constraints, courtesy of the state that is willing to give it your and my money with nothing definitive being asked in return).

Recall the last quote: “the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.” But in Nama’s case – what borrowers with “lower credit risk” can they select? None.

This leaves only option for Nama – to raise the underlying quantity and quality of collateral. Again – can this be done?

Sure, if Nama can either increase seniority of its claims on the collateral, or if it can swap assets for higher quality assets somehow. Alas, this works in theory, but in practice, Nama is saddled with seniority and quality of assets that banks have. It cannot go out to the market and demand that senior debt holders out there step aside and let residual quality claims that Nama might hold to step forward. Nor can it go to the developers and demand that better or more collateral be pledged for the loans. It is neither legally possible, nor feasible, given the dire state of developers’ finances.

Now, step aside and think of the Anglo. Anglo is a bank that is saddled with exactly the same dilemma – poor loans risk diversification. Can it escape this conundrum, assuming it can get funding (remember – Nama has no funding constraint). Of course it can. It can diversify client base and start attracting clients with lower risk profile by offering cheap loans to selected clients. And of course, Anglo has done so in the past – perhaps not enough, but it did. It can go out and lend outside Ireland, to diversify via change of geographies (it has done so in the past as well). And it can load up on collateral – which, once again, Anglo did. And yet, despite doing all these things, Anglo collapsed.

Anyone still thinks Nama – with much more limited ability to diversify key risks – can succeed?

So here you have it – Nama is the ultimately non-diversifiable risk undertaking that is actually worse off in terms of risk profile than the Anglo Irish Bank…


One would hope their board and risk committee understand this. Not really - the board contains such experienced finance and risk people as town managers, and the risk committee - well, that one will be staffed by who knows who, for it will have no one from outside Nama on it.

And this, of course, is where Nama is so nicely reflective of the Anglo...

Economics 03/02/2010: Live Register for January

You've heard the numbers on Live Register results by now, no doubt. A summary, courtesy of CSO:
Here are few charts:
Having breached 430,000 marker this time around, the LR is back on the upward trajectory. As predicted. And with it - unemployment rate:
At 12.7%, we are now in December 1994 territory. Officially, all Celtic Tiger gains in terms of reduced unemployment are now gone. Some 14 years worth of hard labour gone within a span of just 21 months.

Oh, and in case you've heard that we are now doing soooo much better than in January 2009:
It is true - in January 2009, unadjusted LR was rising by 7,251 per week, this January it was rising by 'only' 2,668 per week. Yet, three things worth mentioning:

1. In January 2008 the rate of increases in LR was 2,768 per week - just 100 shy of January 2010;
2. This January saw the highest unadjusted increase per week since July 2009; and
3. Remember - the latest increases are ameliorated by two factors not present in previous years - already high unemployment (meaning that the number of jobs to be cut should be really declining) and high rate of workers outflow from the labour force.
   

Economics 03/02/2010: International hype around Ireland's Fiscal Policies

Nouriel Roubini - an economist I would regard extremely highly, writing today in the Financial Times (a paper I would regard extremely highly) clearly illustrates the point that to international observers, Ireland is hardly important enough to actually engage in fact-checking (here).

"The best course would be to follow Ireland, Hungary and Latvia with a credible fiscal plan heavy on spending cuts that government can control, rather than tax hikes and loophole closures that depend on historically weak compliance. ...This approach is working in Ireland – spreads exploded as public debt ballooned to save its banks, but came back in as public spending was cut by 20 per cent."

Really? We haven't noticed. And neither did the Department of Finance.

First off - Irish fiscal adjustment to date is approximately 50:50 split between higher tax burden and spending savings.

Second, there has been no net reduction in public expenditure in Ireland since 2008. None, folks. Let's face the music performed for us by the Department for Finance. No spin from me. In its "Ireland – Stability Programme Update, December 2009" available to all (including Professor Roubini here) DofF provide some stats.

Start from the top: page 14 of SPU:
Clearly, no sign of decreasing expenditure in sight. Of course there are many reasons for this, but hey, where's that 20% cut? Or 1% cut? None through 2009.

But may be Prof Roubini is talking about future cuts of 20%? Ok, page 20 shows future expected expenditure figures per Budget 2010.
So clearly, neither Gross, nor Net current expenditure are set to fall from 2009 through 2014. Not on a single occasion.

On Capital expenditure side, there are severe cuts. So much is true. But a cut between 2009 and 2010 is just 10.7%, not 20%. The cut between 2009 and 2011 is 23.8% but that is only accounting for 3.11% of the total Net expenditure of the state in 2011. Where's that 20% cut in total expenditure coming from, folks?

DofF plans for a 2.8% cut in the General Government Balance in 2010, not a 20% cut either, and that will leave us (per their rosy forecasts on growth and tax revenue) at 11.6% deficit relative to GDP, down a whooping 0.1 percentage point on 11.7% deficit achieved in 2009.

Oh, yes, while Anglo Irish Bank transfers in 2009 (to the tune of €4 billion) enter the DofF estimates for General Government Balance, there are no provisions for the same anywhere in DofF projections for 2010 (see Table 1c, page 38). So pencil that in and you have No Reduction in Deficit in 2010! In fact, with banks supports still required, 2010 is likely to see an increase in deficits.

Take a look for yourselves:Notice that pesky number on borrowing requirement rising in 2010 on 2009? If Prof Roubini is correct, why would the Government that managed to cut its spending by 20% increase its borrowing by 3%? Unless the revenue side is expected to fall by more than 20%! But no, DofF expects total tax revenue to decline by 4.7% in 2010 (Table 1b, page 37).

Finally, Table 1d on page 40 shows that spending adjustments per Budget 2010 amount to the net of €-4,051,059. Of course, since then we have learned that some of the cuts will not be implemented, reducing this number to some €3.3 billion. But even at a higher level, estimated by the DofF, the adjustments add up to only 8.55% of the Net Voted Total Expenditure, or 6.42% of the Gross Total Expenditure in 2009.

Not even a half of Prof Roubini's 20%!

Hmmmm... someone has been fooled by the PR machine statements coming out of Dublin.

Economics 02/02/2010: NTMA and the banks

Per RTE Business (here which so far cannot be confirmed by any official material published on the NTMA website):

The NTMA "will now hold talks on capital needs with the institutions covered by the NAMA legislation. Among the other responsibilities it is assuming, the NTMA will also hold discussions with financial institutions on their realignment or restructuring within the banking sector. It will manage the Minister for Finance's shareholding in the banks, advise on banking matters, and crisis prevention, management and resolution."

Here are the interesting aspects of this change that raise a multitude of questions:

1. How will NTMA manage the conflict of interest between its own objectives per above and Nama objectives?
2. How will the potential conflicts of interest be disclosed to the markets?
3. What does it mean that NTMA will hold discussions with financial institutions? Will these discussions be subject to usual market disclosure rules or will they risk constituting a price fixing behavior?
   
4. How can NTMA's direct interference with the banks be compatible with the rights of other shareholders?
5. How will NTMA advising on banking matters etc play out vis-a-vis the roles of the Financial Regulator and the Central Bank?
6. What does 'crisis prevention, management and resolution' refer to? Systemic banking crises? Specific institutions crisis? Will it also include industrial relations crises? How will this process be carried out while respecting the general rules of disclosure and non-collusion with the market?
7. With massive firepower and own objectives, how NTMA will assure that the rights and interests of minority shareholders in the banks are protected?

In effect - even the mere raising of these questions implies that there is a risk that NTMA will be engaged in interfering with the markets for shares and debt in Irish banks in markets-distorting fashion. Amazingly we have no details as to how the Government and NTMA/Nama plan to avoid these problems.


There is another issue at hand here. If, at least in theory, DofF is a publicly accountable institution, NTMA by its statues is a secret entity (with extremely secretive culture to boot). What transparency can we, banks customers, have and what assurance can we hold that NTMA will not act to undermine or violate our rights, the safety of our deposits or our ability to access these?


Lastly, I am rather surprised at the timing of this change. In my view, this statement coming before Nama begins transfers of loans suggests that the Government is preparing for taking up a majority stake in the banks - a majority stake that will require full state control of these institutions management and activities.

So is this statement a precursor to full nationalization of the banks?

Economics 02/02/2010: Turning the corner

So we've turned the corner... err... our economy it is... only to discover that, behind that corner the same tumbleweeds keep on rolling across the Exchequer accounts.

It was worth a wait, folks, and January figures for Exchequer returns have shown that, as predicted, the deterioration in our public finances will continue despite Minister Lenihan's efforts in the Budget 2010.

A chart is worth a thousand words:
Tax receipts down on January 2009 by almost 18%. They were down 19% in January 2009 relative to January 2008. Spending, meanwhile, is down 7.5% on January 2009, but... there's always 'but': current expenditure is down by a much lower 5.59% and the slack is picked up by a whooping 21.1% decline in voted capital expenditure (the stuff that is supposed to provide stimulus to our economy through strong public investment programmes).
Check out monthly receipts above and spot the odd on - right, there has been an extraordinary increase of ca 50% (or 250 million) in January 2010 capital receipts. This, of course, is thanks to a massive hold-back on public investment programme in 2009.

What's going on?
Receipts side is clearly gone into a deep red - all, without an exception - lines of tax revenue have underperformed January 2009. Corporate tax has decreased to a third. Stamps - already miserable performer in 2009 are now 41% down on that. Capital gains also sunk by almost a quarter. Income tax, down a massive 9.72% is the best performer. This is dire, folks!

But expenditure side is also showing some poor performance:
Ok, I understand Social Welfare spending increasing 15.76% yoy, but agriculture? ETE is a mixed bag. But, get your thinking going. We are in a recession and in a third year of a fiscal crisis. Over the last two years, we have managed to reduce our spending by a miserable 6.9% or less than 3.4% annualized savings. And that was achieved with a Draconian Budget 2010. what will it take to cut our spending by 25-30% off the peak levels consistent with a structurally balanced budget?

Last picture...

But here is a different way of looking at the expenditure side:
Take the entire set of departments and divide them broadly speaking into primary (vital, if you want) and secondary (supportive) in terms of their roles. Guess which group has manged to achieve greater savings (in percentage terms) out of its budget?

Efficiently run Government would require the secondary set of departments to cut by at least 3-4 times the rate of cuts in the essential departments. Under the above, we'd have cuts of up to 60% in the total spending segment of €660million, or effective savings of €392 million more than has been achieved in one month, or roughly €1.8-2 billion in one year.

Not enough to decrease our massive deficit, but...